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**Slides by Alex Stojanovic**

ECONOMICS ELEVENTH EDITION LIPSEY & CHRYSTAL Chapter 24 INFLATION Slides by Alex Stojanovic

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Learning Outcomes Because inflation and unemployment are closely related, at least in the short term, macroeconomic policy-makers must walk a tightrope with inflation on one side and the unemployment on the other. Attempts to reduce unemployment have often been accompanied by a rise in inflation, and attempts to reduce inflation have usually led to episodes of increased unemployment, which although temporary are often severe. Inflation is related to the output gap and to expected inflation.

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Learning Outcomes Inflation is currently under control in most countries, but this could change if policy-makers change priorities. Inflation is generally considered to be undesirable, especially when it is unexpected, because it distorts the signals that are provided by the price system; it creates arbitrary redistribution from debtors to creditors; it creates incentives for speculative as opposed to productive investment activity; and is usually costly to eliminate.

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UK and world inflation

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**A Single Supply Shock LRAS AD1 AD0 Price level SRAS1 SRAS0 P3 P2 E2 P1**

Y1 Y* Real GDP

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A Single Supply Shock The final effect of a single supply shock depends on whether or not it is accommodated by monetary expansion. A supply shock causes the SRAS curve to shift leftward from SRAS0 to SRAS1, as shown by arrow 1. Short-run equilibrium is established at E1. If there is no monetary accommodation, the unemployment would exert a downward pressure on wage costs, causing the SRAS curve to shift slowly back to the right to SRAS0. Prices would fall, and output would rise, until the original equilibrium was restored at E0. If there is monetary accommodation, the AD curve shifts from AD to AD, as shown by arrow 2. This re-establishes full-employment equilibrium at E2, but with a higher price level, P2.

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**Monetary Accommodation of a Repeated Supply Shock**

LRAS AD2 AD1 SRAS2 AD0 Price level SRAS1 SRAS0 P4 4 E4 E3 P3 3 P2 2 E2 P1 E1 E0 1 Y1 Y* Real GDP

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**Monetary Accommodation of a Repeated Supply Shock**

Monetary accommodation of a repeated supply shock causes a continuous inflation in the absence of excess demand. The initial equilibrium is at E0. A supply shock then takes equilibrium to E1. This is stagflation phase of rising prices and falling output; it is indicated by arrow 1. If the monetary authorities then accommodate the supply shock, the AD curve shifts to AD1 taking equilibrium to E2. This is the expansionary phase of rising prices and rising output (arrow 2). A second supply shock takes equilibrium to E3 (arrow 3) and a second round of monetary expansion takes it to E4 (arrow 4). As long as the supply shock and monetary accommodation continue, the inflation continues.

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**A Validated Demand-shock Inflation**

LRAS AD3 2 AD2 SRAS2 AD1 Price level SRAS1 AD0 SRAS0 P3 E3 P2 E2 P1 1 E1 P0 E0 Y* Y1 Real GDP

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**A Validated Demand-shock Inflation**

Monetary validation will cause the AD curve to shift, offsetting the leftward shift in the SRAS curve and maintaining an inflationary gap in spite of the ever-rising price level. An initial demand shifts equilibrium from E0 to E1 (along the path indicated by arrow 1), taking GDP to Y1 and the price level to P1. The resulting inflationary gap then causes the SRAS curve to shift to the left. This time, however, the money supply increases, shifting the AD curve to the right. By the time the aggregate supply curve has reached SRAS1, the aggregate demand curve has reached AD2, taking equilibrium to E2. GDP remains constant at Y1, while the price level rises to P2.

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**A Validated Demand-shock Inflation**

The persistent inflationary gap continues to push the SRAS curve to the left, while the continued monetary validation continues to push the AD curve to the right. By the time the aggregate supply reaches SRAS2, the aggregate demand curve has reached AD3. The price level has risen still further to P3, but the inflationary gap remains unchanged at Y1-Y*. As long as this monetary validation continues, the economy moves along the vertical path of arrow 2.

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**The effect of inflationary shocks**

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**A Phillips Curve 20 15 Annual rate of change of money wages [%] 10 5**

-5 2 4 6 8 10 12 14 16 Unemployment [%]

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A Phillips Curve Phillips curve relates the level of unemployment to the rate of change of money wage rates. The figure shows a numerical example of a Phillips curve. According to the example, an increase in unemployment by four percentage points, from 8 to 12 per cent, will lower wage inflation from 3 to 2 per cent, while a reduction in unemployment by four percentage points, from 8 to 4 per cent, will raise wage inflation from 3 to 14 per cent.

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**The Phillips and the AS-AD Relation**

SRASD0 E2 P2 [i]. Price level E0 P0 E1 E3 AD0 P3 AD1 Y1 Y* Y0 Real GDP PC Rate of change of unit costs [ii]. - c0 c1 Y1 Y* Y0 Real GDP

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**The Phillips and the AS-AD Relation**

The transformed Phillips curve shows the speed with which the SRAS curve is shifting upwards. When the curves are AD0 and SRAS0 in part (i), they intersect at E0 to produce equilibrium DP of Y0. Part (ii) shows that when GDP is Y0, the rate of change of unit costs, and hence the rate of increase in the SRAS curve, is c0 per cent per year. Thus equilibrium GDP is moving rapidly towards Y* as the point of macroeconomic equilibrium moves up the fixed AD curve towards the long-run equilibrium at E2.

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**The Phillips and the AS-AD Relation**

When the curves are AD1 and SRAS0 in part (i), equilibrium is at E1, with GDP Y1. Part (ii) shows that when GDP is Y1, unit cost, and hence the SRAS curve, will be shifting downwards at the rate of c1 per cent per year. Thus equilibrium GDP is moving slowly along AD1 towards a long-run equilibrium at E3. Each long-run equilibrium has the same level of GDP but a different price level.

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**Rising Inflation [i]. [ii]. SRAS1 SRAS0 E2 Price level P1 E1 P0 E0 AD0**

Real GDP Y* Y1 SRPC2 SRPC1 c3 SRPC0 c2 Rate of change of unit costs - c1 [ii]. Y1 Y* Real GDP

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Rising Inflation The attempt to hold GDP above its potential level and unemployment below the NAIRU will lead to an ever-rising inflation. Macroeconomic equilibrium is originally at E0 with income Y* and a stable price level of P0. The government then adopts measures to shift the AD curve to AD1, taking GDP to Y1 and the price level to P1. Now, however, the unit costs begin to rise at a rate of c1. This shifts the SRAS curve to the left and, to offset its effects, monetary authorities validate the inflation with monetary expansion. As long as the Phillips curve in part (ii) stays constant, inflation proceeds at a constant rate.

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Rising Inflation When the curves in part (i) have reached, say SRAS1 and AD2, people come to expect the inflation to continue at the rate c1. The short-run Phillips curve now shifts upwards to SRPC1, which passes through the point (Y*, c1). With income at Y1 the inflation rate now rises to c2. The SRAS curve now shifts upwards more rapidly and, to maintain income at Y1, the rate of monetary validation must be increased to allow the AD curve to shift more rapidly. Sooner or later the inflation rate of c2 comes to be expected and the Phillips curve shifts to SRPC2, which passes through the point (Y*, c2). The inflation rate now rises to c3, and the rate of monetary expansion must be further increased to hold GDP at Y1.

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**Monetary Accommodation and Steady Inflation**

LRAS SRAS2 E2 SRAS1 P3 SRAS0 [i]. Upward-shifting AD and SRAS curves P1 E1 Price level AD2 P0 E0 AD1 AD0 Real GDP Y* LRPC SRPC ce Expected inflation rate Rate of change of unit costs [ii]. Steady Inflation - Y* Real GDP

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**Monetary Accommodation and Steady Inflation**

Positive expected inflation means that unit costs will be rising even when output is only at its potential level; monetary accommodation can then keep GDP constant and sustain the inflation rate. The expected inflation rate is shown in part (ii) by ce which determines the height of the short-run Phillips curve above the axis at Y*. This translates into an SRAS curve that is shifting upward at a constant rate from SRAS0 to SRAS1 to SRAS2 in part(i). Monetary accommodation means that the AD curve in (i) also shifts upward, from AD0 to AD1 to AD2. As drawn, the monetary accommodation just keeps GDP constant at Y*, so inflation persists at the expected rate ce. The inflation of unit costs in part (ii) is reflected in a constant rate of price increase, with the price level going from P0 to P1 to P2 in part (i). Since expected inflation is constant and the SRAC is stable.

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**UK price levels and inflation rates, 1661-2005**

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**US and Japanese share prices**

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**CHAPTER 24: INFLATION Inflation in the Macro Model**

A shift in the SRAS curve is called a supply shock, while a shift in the AD curve is called a demand shock. A single leftward shift in the SRAS curve causes a rise in the price level and a fall in GDP. Full employment can be restored either by a fall in unit wage costs, which shifts the SRAS curve to the right, or by a monetary expansion, which shifts the AD curve to the right. Repeated supply shocks in terms of leftward shifts of the SRAS curve carry their own restraining force in terms of ever-rising unemployment if they are not accommodated by monetary expansion. If accommodated, they can give rise to a sustained supply-side inflation.

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CHAPTER 24: INFLATION An isolated expansionary demand shock leads to a temporary rise in GDP and a rise in the price level. If it is not validated, output will fall while the price level rises as GDP returns to its potential level. Sustained demand shocks inflation with GDP remaining above potential.

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CHAPTER 24: INFLATION The Phillips Curve The original Phillips curve relates wage inflation to the level of unemployment; suitably transformed, it relates unit cost inflation to GDP. It thus determines the rate at which the SRAS curve is shifting. Unit cost inflation depends on the state of demand – it is positive when Y > Y* and negative when Y < Y* - and on expectations of inflation and random shocks.

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CHAPTER 24: INFLATION The expectations-augmented Phillips curve relates GDP to unit cost inflation and is displaced from the point of zero demand inflation at Y = Y* by the amount of expectational inflation. A sustained inflation at a constant rate is possible only when Y = Y* and the monetary authorities accommodate the inflation. Expected inflation is then equal to actual inflation.

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**CHAPTER 24: INFLATION The Lucas aggregate supply curve**

With the Lucas aggregate supply curve only unexpected shifts in aggregate demand will have real effects, but this result is not generally accepted to apply to today’s economies with their short-term rigidities and long adjustment lags. Policy credibility is important once it is perceived that private agents’ behaviour is influenced by their expectations of the government’s future policy actions. Is inflation dead? The establishment of a low-inflation environment at the end of the 1990s and into the 2000s was aided by the institutional changes that put monetary policy in the hands of central banks with independent control over the monetary policy instruments (as discussed in Chapter 21).

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